The Big Tax Break Donald Trump Gets, But Ordinary Workers Don't

Janet Novack
,
Forbes Staff
I write from D.C. about tax and retirement policy and planning.

Guest post written by

David J. Herzig

Herzig is a professor and the Swygert Research Fellow at Valparaiso University Law School. He writes frequently on taxation.

If you’re a typical worker, each year you tally up your income and deductions, and your tax preparer or your tax software spits out what you owe. But what if rather than paying income taxes based on your wages each year, you were able to calculate your taxes (and your tax rate) based on your average earnings over two, five, 10 or even 20 years? This would smooth out your tax liability and might be a better reflection of your overall finances and ability to pay. It might also be a fairer system.

Indeed, this sort of income smoothing already exists in the U.S. Tax Code, but only for certain taxpayers---for example, those, like Forbes 400 member Donald Trump, who derive their income from ownership in partnerships and pass through businesses, rather than from wages.

That explains why when the New York Times got leaked a page of a state tax return showing Donald Trump reported a $916 million loss in 1995, the newspaper speculated that the Republican presidential candidate might have been able to use his “Net Operating Losses” to wipe out $50 million a year in taxable income over almost two decades.

As Forbes editor Kelly Erb explains here, the ability to carry back and carry forward NOLs has been a part of the tax code off and on since 1918, when it was introduced as a way to help businesses cope with slowdowns after World War I. Carryovers were made vastly more generous under President Reagan in the 1981 tax cut. The law was last tweaked in 1997. Currently, a business can carry a loss back for two or three years and claim a refund from the government of taxes previously paid, or opt to carry the loss forward for as much as 20 years, offsetting profits.

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Those, like Trump, who operate through so-called “pass-throughs”---partnerships and S corps---are able to use those NOLs on their individual returns to offset all sorts of income. (Pass-throughs aren’t taxed at the entity level, but pass through income, deductions and losses to their owners’ tax returns.) Bottom line: NOLs allow those with business income to, over the long haul, pay much less than if they were taxed based only on their yearly income.

Could wage earners, too, benefit from this sort of income smoothing? Consider the sole breadwinner of a family of four (married couple, two kids) who earns $75,000 in year one, then loses his or her job and earns nothing the next year. The first year the family would pay $4,000 in federal income taxes and the second year zero.

But if those two years were averaged, with the family taxed based on $37,500 a year in wages, they would actually receive a $3,800 refund per year as a result of the refundable earned income tax credit and the child tax credit, which is partly refundable. Bottom line: instead of paying $4,000 in federal income tax over two years, they’d get a $7,600 subsidy, for a net swing of $11,600 in the family’s favor.

Sure, that’s an extreme example. Not everyone would benefit as much as this family---or Donald Trump—from income smoothing. But it could help a lot of families.

If you are old enough, this idea of income averaging might sound familiar. Before the tax code was overhauled in the Tax Reform Act of 1986, income averaging was allowed for wage earners. (It made its original appearance in the 1964 Act.)

Income averaging mushroomed in the 1970s according to a Joint Committee of Taxation report at the time, with nearly 7% of taxpayers using it in 1981, up from 1% in 1970. The ballooning number of taxpayers using income averaging, the complication of income averaging (see old Schedule G), and the flattening of tax rates in the 1986 Act, were all used to justify getting rid of averaging for most taxpayers. More to the point, eliminating the technique was projected to raise $1.886 billion in revenue in 1986 and an additional $2.4 billion by 1989.

Today, with the prevalence of tax software, complex complications aren’t necessarily the problem they used to be and some have discussed bringing back income averaging as a matter of fairness. For example Lily Batchelder, a professor of law and public policy at New York University, has proposed allowing targeted income averaging to help the poor, who often have more variance in their income, year to year.

The real lesson from the small disclosure of Trump’s huge returns is that the carry-forward and carry-back of losses is a powerful income smoothing tool for the rich. At best, this might prompt a debate about whether or not an annual income tax reporting system is the fairest system for regular folks and whether they, like Trump, deserve to get some benefits from income averaging.

Herzig is a professor and the Swygert Research Fellow at Valparaiso University Law School. He writes frequently on taxation.